In my first few months at Venrock, I have seen many music deals. I’m happy that entrepreneurs and existing digital music companies have sought me out to look at their companies. The unfortunate truth, however, is that we are unlikely to invest in many music companies in 2009. Here’s why.

The digital music business is not an attractive sector for VCs and investors in general. This is largely due to the economics of the underlying licensing deals. The great mistake the major labels made was to set licensing terms in punitive ways, treating start-ups as predators instead of partners. They still have not realized that they must innovate their way back to consumer relevance. The best way to do that is to partner with leading entrepreneurs. If they treated these relationships as partnerships, they would have set terms which allowed joint business success. But voluntary licenses never allowed for that, and as a result, I can think of only two or three digital music business (out of hundreds) which have built actual businesses on top of licensed music (iTunes, eMusic & Rhapsody — note Pandora is successful but does not depend on voluntary licensing.). Even sadder, the best entrepreneurs have moved on. I have seen dozens of great pitches in the past few months and none are around music.

I don’t expect this reality to change in any meaningful way in 2009. The record labels and publishers need a generational shift in their management teams and a drastic alteration to their compensation structures to encourage risk-taking, investment in new businesses, and allow for cannibalization of their existing, declining business. They need to embrace come-one, come-all licensing, offer simple, transparent and equitable licensing without demanding arbitrary advances and guarantees. Otherwise, the only businesses which reach scale and are interesting to consumers will be the infringers (like Project Playlist) which we’d never fund as infringers.

I honestly hope this all changes. I still believe there are far more interesting digital music services that consumers would support, but there is little incentive for great entrepreneurs to build them.

Couldn’t agree more. There are some outliers taking different approaches – hype machine being the most prominent. But like you – I view the licensing regime now as adding enough friction in the process that consumers end of going elsewhere – ie. the free store.

And while HypeMachine is very useful to many of us, and we all love Anthony, once it gets a little larger, it is likely to be litigated against or killed through punitive negotiated licensing terms. Thanks for your comments, Andrew.

I’m curious, David. You mentioned that the major labels “set licensing terms in punitive ways, treating start-ups as predators instead of partners”. Without disclosing specific details of negotiations that you got involved, would you mind elaborate why you think the labels’ terms are punitive:
1) they restrict the use of purchased music (i.e. insisting on DRM), or
2) they set the royalties too high, or
3) both

If you were the labels, how would you propose licensing terms that would be fair to both sides?

Let me count the ways…
– for digital retail, they allow for a maximum of effectively 15% gross margins, which do not allow stand-alone digital music retail businesses to survive as stand-alone retailers
– for streaming businesses, they price on-demand streams at a $10CPM which means in order to achieve even 40% GM you’d need to sell ads a $17CPM which doesn’t happen.
– they demand enormous amounts of equity for no capital in, often on the order of 5% – 10% of the company (for each label, meaning 20% – 40% of equity to just the four majors)
– they demand enormous cash advances as guarantees, on the order of $1M – $5M per label

Clearly these are terms not meant to establish successful new businesses, but to achieve as much short-term benefit as possible (i.e., cash to the label) and take no risk in getting new business to succeed.

Wow, those terms do sound punitive. It’d be really hard to build a business solely selling digital music.

Regarding labels wanting a 20-40% piece of startups, I guess this only applies for new businesses wishing to sell their music. If Abercrombie & Fitch, for example, would one day like to sell music along with clothes in-store and online, I assume labels can’t demand a piece of the retailer, can they?

So, the bottom line is, a viable business model for would-be music startups could be:
1) Selling stuffs (goods and/or services) along with the music, or
2) Helping established businesses do the above

Supposedly the labels are getting down to $0.005 per on-demand stream, at least in conjunction with an equity stake. This still requires a $5 CPM per *track*. If a listener streamed continuously (for example, a playlist) over the course of an hour, the required CPM would be ~15 tracks (roughly 4 min apiece) x $5 = $75 CPM for the hour.

If the listener happened to click through 5 pages during that hour, a CPM of [$75 / 5 / .4] = $37.50 per *page* would be needed, at 100% sellout, to achieve a 40% GM (to say nothing of composition royalites and bandwidth for the moment). This is off by at least an order of magnitude.

Any unlicensed on-demand service (e.g. Playlist, The Hype Machine, Seeqpod, Songza) will have to pay similar rates if they wish to stay in business and avoid legal suit over the long term (i.e. once the Major decide to pursue them). Advertising can’t support an on-demand model.

OTOH, the compulsory license for radio-style webcasting, while expensive, was $0.0014 per track in 2008 (about 28% of the “cheaper” on-demand rate), and there sounds to be some chance that this rate will decline in 2009 as a result of the SoundExchange-DiMA negotiations happening pursuant to the Webcaster Settlement Act passed in Sep.

Whether the rates will be reduced by enough to allow a purely ad-based model to thrive remains to be seen.

David, thank you for your comments and for taking the time to do the math that I did not. I agree, even with the potentially reduced per-track on demand fees, there is no room for a business here. The major labels know this. They are not interested in seeing new businesses built atop licensed music thrive. To many old-school music execs, they would view that as failure on their part. In the meantime, I am hopeful 8tracks, Pandora, and others built atop the compulsory rates will find a way of eking out some margin and surviving.

I completely agree with you that the labels have made it immensely difficult for music technology companies by withholding their valuable content licenses or making it exorbitantly expensive.

That’s why the only music startups I am bullish on are those that have been able to build great experiences without the major label licensed content or are actively looking to dis-intermediate the majors.

The major record labels have made it very difficult for start ups to present music in fresh and interesting ways. However, there still needs to be any easier way to find good music regardless of where it comes from.

Groovetap allows artists to upload their music and create profiles for free promotional use. Therefore, allowing fans, venues and artists to link up with each other in this social network to help local and global music scenes flourish.

Until there is realistic mutual benefits on all sides, this will remain to be a challenge.

I agree that can never work for all the reasons expressed above, its a margin struggle at the very least.

The flaw in the assunption is to lump in all music start ups with licensed model.

Lizard King Media is about facilaitating new artists and we have been successful in turning a $50k investment ( The Killers) into a $25 mio gross ( the first LP sales in the UK 2.1 mio) or Santigold, our latest act from $30K to $5mio gross. Thats our MO.

Invest early in artists that have merit, and a niche, build out from the niche and control the investement against the demand, and involve the fans via our software toolset http://www.emusu.com.

It isnt the boarded up mansions of the majors catalogue we want but the musical originators of the future. Thats where the money is.

Thanks for your post, Martin. And congrats on your success with Lizard King Media. As you can probably tell from my past, I remain one of the biggest champions of indie labels and the music they bring to the market. Your success with The Killers and Santigold is testament to the marketing and artist development innovation alive and well in the indie label sector. I did not include indie labels in my discussion above largely because, to my knowledge, they have never been VC-backed and are almost never the focus of VC investment in general.

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